Monday, October 12, 2009

Bags Don't Fly Free

As a frequent Southwest passenger, paying for checked baggage is not quite commonplace for me yet, since Southwest is a firm proponent of bags flying free. As any traveler is well aware, many airlines now charge an additional fee for checking baggage, averaging roughly $20 per bag. However, I was initially surprised when I recently checked in online for my US Airways flight, and was offered the option to declare the number of bags I’d be checking and thus pay a reduced price of $5 less per bag.

Although at first glance you might be tempted to think this is a classic example of price discrimination, further examination will reveal other possible explanations for this pricing disparity. If price discrimination were the sole justification for the two different prices, this would mean that US Airways is trying to extract additional consumer surplus (and thus increase profit) by segmenting the market into those who check in online and those who don’t. Based on the pricing differences, this would mean that US Airways believes that those passengers who check in online have a lower willingness to pay than those who check in at the airport.

However, there is reason to believe that many passengers who check in online might actually have higher willingness-to-pays than other passengers, as they are likely to be business travelers who are either in an office with wifi or have internet connections on their phones. Since business travelers tend to have a more inelastic demand for travel services (mostly since they do not directly incur the expense), an argument could be made that this market segmentation isn’t the most profitable.

An alternative, and more plausible, explanation for the two different prices is that US Airways is creating an incentive for passengers to declare the number of bags they’ll be checking and pay for them ahead of time. Incentives are at the core of economic analysis, so this result isn’t incredibly surprising. By charging a lower price to those passengers who “check bags” ahead of time, US Airways is inducing passengers to plan ahead. Some possible justifications for why they would want to do this are as follows:

  1. Paying for bags ahead of time reduces the wait time for passengers seeking to check in at the airport. This makes customers happy and more willing to fly US Airways, and perhaps lessens the need for extra employees working the check-in booths.

  2. If passengers declare the number of bags they are checking ahead of time, US Airways can more accurately predict the number of bags that will be on the flight and perhaps the need for overhead space in the cabin.

Discussion Questions:

1. If US Airways’s goal is to increase profits through price discrimination, is the market segmentation they are using appropriate? Can you think of any other existing ways that airlines segregate their markets?

2. How does this information friction about the price of checked bags affect efficiency in this market?

3. Can you think of other markets where different pricing mechanisms exist in order to incentivize a particular action, such as cities charging for trash removal but providing free recycling services?

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Wednesday, October 07, 2009

Towards Gasoline Market Efficiency

For the past year or so, I’ve been using the same website to save money on gasoline. The parent site of the one I use is Gas Buddy. Commuting to work I spend about $130 per month on gas, or roughly $1,550 per year. There are several reasons for this. Gasoline is one of my biggest work-related expenses, California gas prices are consistently among the highest in the nation, and I’m also an economist. I feel impelled to fill up at the station offering gasoline at the cheapest price, without going significantly out of my way to get there, of course.

Economic theory would typically classify a local gasoline market as a competitive market, yet, I often see differences of 20-25¢ per gallon for the same gasoline grade among nearby stations. Why does the standard model of competition not seem to apply here? Because most consumers probably accept the notion that gasoline of the same grade is nearly identical regardless of the station, competition should drive prices to the same competitive market clearing price. However, gasoline retailers often try to differentiate their product through methods such as affiliated credit cards, which give the holders a discount when they purchase gas with the card from a retailer that is part of the corporate chain. Another strategy they use is to offer a discount on a car wash to consumers who have purchased gas at their station. Nevertheless, it doesn’t seem like such differentiation would be important enough to keep the market from a perfectly competitive equilibrium.

What else might explain these facts? One possibility is that some gas stations employ a strategy of luring customers into their stores with gasoline sold below cost, to sell them high margin convenience goods. Another possibility is that some stations enjoy location advantages that allow them to command higher prices, such as the first station located off of a high traffic freeway exit. Nevertheless, the explanation that I prefer is that gasoline consumers do not have all of the information regarding prices of gasoline in surrounding areas. Websites like Gas Buddy help alleviate this informational deficiency in a nearly costless way thanks to its gas price maps and price lists. As more people use the site, the local gasoline markets covered should theoretically approach a perfectly competitive equilibrium.

Where does the website get its price information? People who are interested in either winning gas cards or making the gas market more efficient have accounts on the site and post gas prices there. Although there are obvious benefits to the information provided by Gas Buddy, there may also be drawbacks to the site. Besides the obvious damage to the profits of gas station companies, there are likely to be people who misuse the information. For example, imagine the user who drives several miles out of his way to fill-up on gas that is only 5 cents cheaper per gallon than the nearest station. This person may save $.75 or so, but environmental costs of the extra driving distance, the cost of the additional gasoline used and vehicle wear, and the value of the person’s extra driving time are likely to sum to significantly more than $.75. So, while getting the cheapest gas is great, remember that there are more to costs than just retail prices.

Author’s note 10/19/09: During her review of this post, Kasie Jean mentioned the possibility that consumers may have gasoline brand loyalties. The author found this unlikely but later received advice from a trusted mechanic regarding the benefits of Chevron with Techron gasoline. The author owns no securities issued by the Chevron corporation.

Discussion Questions

1. Now that you are aware of a gasoline price website, would you use one to locate the cheapest nearby gas prices? Why or why not?

2. Think about the characteristics of perfectly competitive markets. Do you believe that gasoline markets are perfectly competitive? If not, what are some aspects, besides those described above, that keep them from perfect competition?

3. In 2007, a study concluded that the optimal tax on gasoline was $2.10 per gallon. What is your opinion of this conclusion? Do you think that gas price websites would be viewed more if gasoline taxes were significantly higher?

4. In what other ways has the internet made markets more efficient or perhaps less efficient?

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